14.02 Principles of Macroeconomics
Problem Set 1(Suggested Solution): Spring 1998

1. a) False. Inflation is below its historical average also in Europe and in Japan. (See tables for inflation, output and unemployment in Ch.1)
b) False. From Figure 1-8 (in the text) you can see that the Japanese trade surplus has fluctuated
c) False. The combined GDP of the European Union was larger than the one for the US in 1994, the population was also larger. However, the standard of living (GDP per capita) was higher in the US.

2. There are several possible explanations:
- Increased productivity of the current population of workers If output per worker is increasing, then output can grow without any increase in employment.
- Use of overtime
- Increased productivity of current capital
- The labor force may be rising, but if employment grows more slowly than the labor force the unemployemt rate will rise.
It usually takes a large increase in output (above 2.5%) to decrease unemployment.

3. a) No, this is an intermediate sale. The transaction will be counted as part of GDP through the restaurant revenues.
b) Yes, this is a final service.
c) Snow-shovelling is a final service and should be counted as part of GDP. However, it's unlikely that this transaction will ever be recorded, it's part of the underground economy (unmeasured economic activity)
Participation in MIT experiments is tracked down with your SS number. However, it is not a final service. Basically, your revenues are sombebody else's cost.
d.- This is a payment for an intermediate service, therefore it is not counted as part of GDP at this stage.
e.- Purchases of used goods are not counted as part of GDP.

4.a) Final Production: GDP = $500.000 , final purchases by consumers
b) Value Added Approach:
Value added in farming = $200.000 (no intermediate inputs)
Value added in baking = $500.000-$200.000 = $300.000
Total Value added= $500.000
c) Income approach
Wages in farming ....$100.000
Wages in baking......$200.000
Total wages = $300.000
Profits in farming= $200.000 - $100.000 = $100.000
Profits in baking = $500.000 - $200.000 - $200.000 = $100.000
Total profits = $200.000
Total income = $500.000

5. The CPI is an index of the aggregate price of consumption goods, where as the GDP deflator is an index of the aggregate price of output. Some of the goods in GDP are sold to firms, the government or to foreigners, rather than to domestic consumers. Changes in the prices of imported consumption goods will affect the CPI but not the GDP. For countries with different GDP composition and different degree of openness, the discrepancies between both may be important.

6. Your answer to this question may vary, but remember that the CPI reflects the evolution of consumption goods prices, once you determine the typical basket of consumption for your two populations, you have to make a case that the price for one of the baskets has increased at faster/slower rate. The fact that a professor may have a BMW and a student a second-hand Chevy, does not say anything about how the price of those two goods evolves over time.


Year 1996 1997
Nominal GDP 4.501.600 5.101.800
Real GDP (p_96)(*) 4.501.600 5.301.200
Real GDP (p_97) 4.352.400 5.101.800
GDP deflator (p_96) 1 0.96238
GDP deflator (p_97) 1.03428 1

(*) Real GDP (base p_i) = Nominal GDP/GDP deflator(base p_i)
Real GDP growth (p_96) = (5.301.200 - 4.501.600) / 4.501.600 = 0.1776, 17.76%
Real GDP growth (p_97) = (5.101.800 - 4.352.400) / 4.352.400 = 0.1722, 17.22%
Inflation (p_96) = (0.96238 - 1) /0.96238 = -0.0391 , -3.91%
Inflation (p_97) = (1.03428 - 1)/1 = 0.03428, 3.43%
Different base years will give different answers, one cannot say that one is more correct than the other.

8. Accuracy of tests administered, number of tests, time spent with physician and nurses are just an example of things one might want to consider. If we account for these factors, the large increase in prices usually associated with medical costs, may not be that large.